The buyside trader - empowered or extinct?

The introduction of Reg NMS next year will further compound other changes, such as decimalisation, that have transformed the equity market in recent years. Joe Wald, CEO of EdgeTrade Inc., explains how traders need to evolve and respond to meet this challenge if they are to remain relevant in the new environment.

The introduction of the SEC's Order Handling Rules in January
1997 represented a watershed for the US equity market. The rules
required market makers to display client limit orders (or place
them into a qualified ECN) that were not immediately executed and
were priced at or better than the market makers' own current
quotes. This was one of the factors that drove the emergence of
direct market access (DMA). Since then, other developments have
changed the way buyside traders operate. Reg NMS will shift the
pace of this change into a higher gear (among other things it
will drive the re-emergence of DMA - see Figure 1) and those
traders who do not evolve and adapt in response are effectively
running the risk of extinction.

Heed the call of change

Already, we can see a very distinct division emerging between
those traders who realise that this is a challenge to face up to
if they are to survive, and those who don't. Those who don't,
fall into two sub-groups. One sub-group assumes that algorithmic
trading and DMA will stall and therefore they need do nothing.
The other sub-group believes that while algorithmic trading and
DMA may take off there is no onus on them to do anything about it
- their life will just become easier, as the technology does all
the work.

Both these sub-groups are heading for a rude awakening. To all
intents and purposes, when Reg NMS is aggregated with all the
other recent market changes, the result will be a marketplace
where it is effectively mandated that electronic systems must be
used for trade execution. In terms of how traders use those
electronic systems, the competitive bar will also be rising.
Therefore, those traders with the skills to leverage electronic
systems to the maximum will have the advantage.

Education and effort

To gain that advantage requires an education process. Traders
need to immerse themselves in the technology to develop a strong
understanding of direct market access and how it interacts with
the new market structure. At the same time, they need a firm
grasp of algorithms and how best to use them in facilitating the
trading process. Finally, they need to evaluate transaction cost
analysis to appreciate the impact their trading has on the
marketplace. To do this, they will also need to analyse their
trading venues and the implications of using various trading
partners.

This is a challenge, but it isn't an insuperable one. For
example, in the case of algorithms, traders do not need to
understand the quantitative details or the nuances of FIX
connectivity. Instead they can focus on the practicalities, such
as how the algorithms operate in the market and react to various
situations or types of events.

Some traders may feel tempted to take it easy, and assume that
their pre-trade analytics will make the decisions for them: this
is a mistake. Pre-trade analytics are an effective tool in some
ways and misleading in others. They are valuable in terms of
highlighting the trades in a list that might be problematic and
therefore require greater attention from the trader. However,
they cannot predict the future or replace human judgement.
Ultimately, pre-trade analytics are a decision support, not a
decision replacement, tool.

Figure 1

Integration and collaboration

Only when traders have a solid understanding of the technologies,
markets and trading partners at their disposal can they start to
think about how to integrate all these into a homogenous and
effective trading style. Algorithms and technology cannot
replicate all a human trader's skills - they may be highly
appropriate for some trades and not remotely suitable for others.
Therefore, one of the new skills that the empowered trader needs
to develop is the ability to understand which parts of his/her
traditional role to hand off to the technology and which to
retain. That isn't a static process - markets are dynamic and the
way in which an algorithm performed yesterday isn't necessarily
the way it will perform today, so trades originally passed to
algorithms may have to be taken back for manual execution, and
vice versa.

The understanding gained from these learning and integration
processes also allow the empowered trader to collaborate more
effectively in the design of new algorithms that will assist them
in their role. We have found that those traders who already have
a good understanding of how existing algorithms interact with the
market are highly effective participants in this sort of creative
development. On the one hand they can express their requirements
very clearly. On the other, they are an invaluable source of
wellinformed feedback. The most conducive backdrop for this
collaboration between a trader and his algorithmic provider is an
agency-only firm that poses no conflict of interests such as
proprietary trading, market making and data mining. By contrast,
where there is a potential conflict of interest, the benefits of
any collaboration will obviously be impaired by confidentiality
concerns.

Figure 2

Choose your partners

Apart from understanding and choosing the appropriate
technologies, the empowered trader will have a further challenge
as Reg NMS approaches - picking the right trading partners. The
last two years have seen a lot of broker activity, such as buying
stakes in execution venues and building internalisation engines.
The snag is that many traders wrongly assume that because they
cannot be traded through, post Reg NMS, these developments will
not affect them.

Not so. In order to be competitive, traders will need the best
possible order routing and direct market access tools. The trader
who wishes to be empowered will be asking questions like, "If my
broker owns an execution venue, will it be as quick in routing my
order to a venue where it can trade at a better price as my own
independent DMA/routing tools?"

Final thoughts

Those buyside traders who still think sitting on their hands is
the best response to the future might care to consider the
numbers. They prove beyond question the increasing predominance
of technology in equity order execution.

TABB Group's 2005 Institutional Equity Trading Report (see Figure
2) shows phone broking dropping from 48% of volume traded in 2004
to 31% in 2005, and with a projection of 20% for 2007. Both
algorithms and ECN/DMA rise inexorably over the same period.

In the light of that alone, masterly inactivity is clearly not a
great career move - but this is only one of the most obvious
examples of how the market place is changing.

Responding to this change will require traders to make an effort
on several fronts: learning about DMA/algorithmic technology,
understanding how to integrate that to best effect with their
trading style, and re-evaluating their trading relationships to
identify conflicts of interest. Only those traders prepared to
take these steps will be empowered - those who bury their heads
in the sand risk extinction. .